Is R-I-S-K Really a Four-Letter Word?

It is to someand it is certainly something that most people try to avoid. But in
the investment world, risk is impossible to avoid. In fact, risk and long-term
rewards are generally related.

Low-risk investmentshigh-quality bond funds
and other fixed-income alternatives—produce
more annual income and are more stable, but
have no real growth potential.

High-risk investmentsdiversified stock
holdingscan bounce around in value each
year, but they offer the potential to grow in
value in real, after-inflation terms over long
time periods.

That’s why, for long-term investors, risk
can actually be a good thing. Indeed, successful
long-term investors understand that without the
presence of risk, there is no potential for reward.

The trick is to get risk to work for you, and
not against you.

How Do You Manage Risk?

Risk is tamed primarily by reducing it down to an
acceptable level. Here are several important ways:

Use asset allocation to diversify among
different asset classes. Bonds and money
market funds offer income and stability,
while stocks offer growth. Each serves a useful
purpose, and you should use asset allocation
to diversify across all three classes, even if you
want to give primary emphasis to one.

Diversify among different fund categories.
Don’t view the riskiness of a single fund
in isolation. Instead, see how each fund
meshes with others you own. A mix of
dissimilar fundsfor instance, a small-cap
stock fund combined with a large-cap stock
fundcan calm your overall portfolio.

Set your sights on the long term. If you
are a long-term investor and have the time
to be patient, you can benefit from “time
diversification” in your stock holdings.
Diversified stock portfolios are volatile
year-to-year, but overall the good times
have outweighed the bad. If you hold
a diversified stock portfolio for many
years, the year-to-year variations become
less important.

Don’t try to “time” the market. Some
investors move between the extremes of
100% stocks to 100% cash when they feel
the stock market may turn down. You should
resist the temptation. Markets are inherently
unpredictable. Participation in the best up
months is far more important than avoiding
the worst down months, and the really
dramatic upward surges in stocks are
unpredictable and usually of short duration.

Be disciplined and use dollar cost averaging.
Dollar cost averaginginvesting, say, $100
monthly in a specific stock fund—is a great
way to build wealth and cope with market
ups and downs. Your periodic fixed-dollar
investments buy shares during all different
kinds of market environments. Your 401(k)
plan presents the perfect opportunity both
to be disciplined and take advantage of
dollar-cost averaging.

There’s no such thing as a
risk-free investment. So
face risk head-on by
understanding and managing
it to your advantage.

The Many Faces of Risk

In the investment world,
there are many different
kinds of risk. Here are
three of the biggest risks
facing 401(k) plan
investors:

Inflation Risk: Inflation
nibbles away at the real
value of fixed-income
interest and principal
payments. Long-term
bond funds are
particularly vulnerablethey are extremely
volatile in terms of
principal, and offer no
growth over the long
term. Money market
funds barely keep pace
with inflation, and
therefore offer no real
purchasing power growth.

Market Risk: Corrections
and bear markets drag
down the returns of even
the strongest stocks.
Stock portfolios are the
most vulnerable over
short time periods, when
plunges as deep as 30%
are possible.

Interest-Rate Risk: When
interest rates rise, bond
prices fall, lowering the
value of existing bonds.
Bond fund investors face
this risk directly, and the
longer the maturity of a
bond or bond fund, the
greater the risk.

The American Association of Individual Investors is an independent, nonprofit corporation formed for the purpose of assisting individuals in becoming effective managers of their own assets through programs of education, information and research.